Monday, March 30, 2009

This is another of what Larry Kudlow calls "mustard seeds" of recovery. This index of the stocks of 18 leading home builders is up over 40% from its late November '08 low. That was over three months ago. The housing news continues to be bad, but on the margin, the news is less bad with each passing day. We've most likely passed the inflection point, where the rate of decline starts becoming less and less. Soon or later we could see the news actually become positive. The market is already beginning to figure this out.

It says that the market rally, and subsequent profit the banks were able to book in Jan/Feb, were a result of AIG unwinding CDS positions off market at insanely profitable levels for the counterparties. The change in the ISDA guidelines in 2001-2002 made this trade/transfer conveniently possible.

This was a one-time transfer of wealth from the taxpayers to the banks without a hint of restraint or regulation, all the while the US debt load continues on its meteoric rise north. Until corruption and greed are restrained to a level that is manageable, there will not be healing in this country. Sadly, we are currently light years away from that inflection point…

I'm intrigued by the Zero Hedge blog. Obviously the guy knows a lot about the inner workings of the institutional finance market. It's a bit technical for the layman. If I try to boil it down to simple English, this is what I get:

AIG owned a ton of corporate debt (because it had sold a lot of protection on corporate debt), and it was being carried at a huge mark to market loss, since corporate spreads had risen significantly since the time the debt was purchased. But spreads started to tighten a lot in January and AIG apparently took advantage of this to sell most or all of their positions, since the taxpayer was going to absorb the loss.

According to Zero Hedge, the banks that bought this debt paid prices that were below market, presumably because AIG was so desperate to liquidate its positions. The banks then turned around and sold the debt at higher prices to others, and this was the source of big bank profits in Jan/Feb.

That may all be true. And if so, what it means is that after essentially taking over AIG, the government in effect ordered a forced liquidation of its positions. There's no doubt in my mind that this resulted in incredible opportunities for those willing to buy AIG's positions.

But in the end this is what everyone wanted: institutions like AIG had become trapped by super-depressed prices for their assets, and they had to shift the assets to others and to do that you have to have lower prices.

It would have been better for the government to not intervene and let AIG work out of its positions on its own. But the market was clamoring for a solution and the politicians were eager to provide it. That this will prove costly to the taxpayer is not exactly surprising.

Caution: I've only read this once and I'm not an expert on these things, so I could be missing a big point.